Tag: Medicare Part B

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Roth IRA

5 Ways to Reduce Your Tax Liability Using Roth IRA Conversions

One of the most important financial goals for retirees is maximization of after-tax income. There are two ways to accomplish this: (a) maximize pre-tax income and (b) minimize income tax liability. A Roth IRA can go a long way toward helping you achieve the latter.

There are two ways to fund a Roth IRA: (a) annual contributions and (b) conversions. Annual contributions, in and of themselves, generally won’t result in a significant source of retirement income due to the relatively low limitation – currently $5,500 or $6,500 if you’re age 50 or older. In addition, eligibility to make Roth IRA contributions is limited to the extent that your income exceeds defined limits.

Roth IRA conversions, on the other hand, have the ability to generate substantial after-tax income while also reducing income tax liability for up to 20 to 30 years or more of retirement. Since income tax liability on the value of Roth IRA conversions will need to be paid, timing of conversions is key. See the May 10, 2010 post, Be on the Lookout for Roth IRA Conversion Opportunities, for a discussion of this topic.

There are five ways that you can potentially reduce your income tax liability and increase your after-tax income during your retirement years by doing Roth IRA conversions.

1. Never pay income tax on the growth of your Roth IRA

While you’re required to include the value of your IRA, 401(k) or other qualified plan assets that you convert to a Roth IRA in your taxable income in the year of conversion, 100% of the growth of your Roth IRA is excluded from taxation. This is true whether or not you ever take any distributions from your Roth IRA.

Individuals who did Roth IRA conversions in March, 2009 when the Dow dipped below 7,000 didn’t mind paying income tax on those conversions in retrospect given the fact that the Dow is currently hovering over 17,000 less than six years later. The income tax savings on the growth of the equity portion of their converted accounts over this period of time plus future potential growth is significant for those in this situation.

2. Roth IRA accounts aren’t subject to required minimum distribution rules

If you don’t do a Roth IRA conversion, 100% of the value of your traditional IRA, 401(k), and other qualified plan assets, including appreciation, will be subject to IRS’ required minimum distribution, or RMD, rules. These rules require you to take annual minimum distributions from your retirement plan accounts beginning by April 1st of the year following the year that you turn 70-1/2. 100% of distributions reduced by any allowable portion of nondeductible contributions are taxable.

As an example, suppose you were born on January 7, 1940 and you own a traditional IRA account with a value of $500,000 on December 31, 2013, you would be required to take a minimum distribution of $21,008.40 from your account by December 31, 2014 and include it in your 2014 taxable income. If instead you owned a Roth IRA account with the same value, you wouldn’t be required to take any distributions from your account.

3. Potentially reduce net investment income tax

The RMD rules sometimes force people to take distributions from their taxable IRA accounts that they don’t need. Often times, they transfer RMDs from their taxable IRA account to a nonretirement investment account and leave them there. For individuals with high levels of income, this can result in additional taxation as a result of subjecting the earnings on their nonretirement account to the net investment income tax of 3.8%. This isn’t an issue for Roth IRA account holders since the RMD rules don’t apply to them.

4. Roth IRA distributions aren’t included when calculating taxable Social Security benefits

The taxation of Social Security benefits is dependent upon your combined income and tax filing status. Combined income includes adjusted gross income, nontaxable interest, and 50% of Social Security benefits.

Single filers are subject to tax on 50% of their Social Security benefits for combined income between $25,000 and $34,000 and up to 85% of benefits when combined income exceeds $34,000. Married filing joint taxpayers are subject to tax on 50% of their Social Security benefits for combined income between $32,000 and $44,000 and up to 85% of benefits when combined income exceeds $44,000.

Roth IRA distributions aren’t included in adjusted gross income, therefore, they don’t affect taxation of Social Security benefits.

5. More opportunities for income tax bracket planning

For all taxpayers, taxable income is subject to seven different rates of tax ranging from 10% to 39.6% depending upon the amount of taxable income. Given the foregoing four potential ways of reducing taxable income and associated income tax liability, Roth IRA conversions can also reduce the income tax rates that are used to calculate income tax liability on other sources of income. This allows for more opportunities for income tax bracket planning to potentially further reduce income tax liability in one or more years.

Although it’s not income-tax related, one other potential benefit of Roth IRA conversions that shouldn’t be overlooked is their impact on the calculation of Medicare Part B premiums. Monthly Medicare Part B premiums currently range from $104.90 to $335.70 depending upon tax filing status and the amount of modified adjusted gross income from two years ago. Roth IRA distributions aren’t included in the calculation of adjusted gross income. As such, they don’t affect the amount of Medicare Part B premiums paid.

As you can see, assuming (a) you can get over the hurdle of prepaying a portion of your income tax liability when you do Roth IRA conversions and (b) you have sufficient nonretirement funds to pay the tax, this can create several tax reduction opportunities as well as a potential reduction of Medicare Part B premiums throughout your retirement years. These benefits, combined with the ability to eliminate taxation on the growth of Roth IRA accounts, can result in greater and longer-lasting after-tax retirement income compared to not doing any Roth IRA conversions.

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Social Security

The Smooth COLA

Remember the old Dr Pepper commercials promoting the fact that this famous soft drink, which was created in the 1880s and was first nationally marketed in the United States in 1904, was “so misunderstood.” I’m a firm believer that this saying also applies to a non-soft drink COLA brought to you by the Social Security Administration.

Every year since 1975, the Social Security Administration calculates a cost-of-living adjustment, or COLA. The 1975 – 1982 COLAs were effective with benefits payable for June in each of those years. Since 1982, COLAs have been effective with benefits payable for December.

The COLA has always been based on an annual increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Since 1983, COLAs have been calculated using increases in the CPI-W from the third quarter of the prior year to the corresponding quarter of the current year in which the COLA became effective. The 2012 COLA of 1.7% was announced in October and will apply to benefits payable beginning in December.

Per the Social Security Cost-of-Living Adjustments table below, there were sizeable annual increases the first eight years from 1975 to 1982. The increases ranged from a low of 5.9% in 1977 to a high of 14.3% in 1980, averaging 8.7% during this period. The COLA decreased to 3.5% in 1983 and further declined to 1.3% in 1986 before climbing to over 4% for four straight years beginning in 1987. There have been only two years since 1982 when the COLA exceeded 5% (1990 – 5.4% and 2008 – 5.8%). There were also two consecutive years recently in 2009 and 2010 that saw no increases.

Since its roaring start the first eight years, average COLA increases have declined dramatically and have remained consistent over extended periods of time. They have averaged 2.6%, 2.5%, and 2.9% for the last 10-, 20-, and 30-year periods, respectively. As a result of their initial jump start, COLA’s have averaged 4.1% over their 38 years of existence.

Although average annual increases have remained below 3% for extended periods of time over the last 30 years, Social Security recipients have kept up with inflation as measured by the CPI-W. Someone still alive today who started receiving benefits in 1975 has seen a 354% increase in benefits, with 108% of the increase attributable to COLA’s during the first 10 years. For the individual who began receiving benefits in 1982, her benefits have increased by 134% over the last 30 years. Benefits have doubled over the last 25 years as a result of COLA’s.

With only two COLA’s exceeding 4% in the last 20 years (4.1% in 2005 and 5.8% in 2008), the pace of the total increase in Social Security benefits has declined significantly. If you began receiving benefits 20 years ago in 1992, you have seen an increase of 63%. If your start year was 2002, your benefits have increased by 29%. Finally, the total increase over the last five years has been only 11%.

Despite the fact that Social Security recipients have enjoyed sizeable cumulative increases in their benefits over the past 20+ years, another reason why COLAs are often misunderstood is due to their accounting treatment. Social Security benefits are reduced by the Medicare Part B premium that helps pay for doctors’ services and outpatient care. The monthly premium for most individuals in 2012 is $99.90. Although Medicare premium increases cannot be greater than the COLA, Social Security benefit increases are diluted to the extent of any increase in Medicare premium.

Enjoy your COLA’s!

 

Categories
Social Security

Plan for the Frays in Your Social Security Blanket – Part 2 of 2

Retirement Income Center

Part 1 discussed some of the historical events in connection with changes to the Social Security system that has resulted in a reduction of benefits received and ongoing questioning of the security of the system, itself. As discussed in Part 1, these changes include no cost of living adjustment, or COLA in 2009, potential taxation of up to 50% of benefits beginning in 1984, and an increase in potential taxation of benefits from up to 50% to up to 85% beginning in 1993. This post will discuss some additional changes that have reduced or delayed the commencement of receipt of one’s Social Security benefits.

Even though it would be 65 years (how ironic!) from the enactment of the Social Security Act in 1935 until the beginning of the reduction of the magical age of 65 for receipt of full retirement benefits, April 1983 Social Security reform gradually raised the retirement age. Beginning in 2000, unless you were born in 1937 or earlier, the commencement of a full retirement benefit has been delayed until a specified age after 65 depending upon your year of birth.

For each year of birth between 1938 and 1942, there is an increasing two-month delay in commencement of benefits from age 65. Individuals born between 1943 and 1954 must wait until age 66. For each year of birth between 1955 and 1959, there is a two-month delay in commencement of benefits from age 66. Finally, for those born in 1960 and later, 67 is the eligibility age for receipt of full retirement benefits.

Beginning in 1961, one could elect to receive a reduced benefit of 80% of the otherwise payable full retirement benefit beginning at age 62. With the 2000 initiation of the delay of the commencement of payment of full retirement benefits until after age 65 for those born in 1938 or later, the 20% reduction in benefits for those electing to begin receiving Social Security at age 62 also increased.

The 20% reduction for age 62 benefit commencement increases by approximately 0.8% for each year of birth between 1938 and 1942 until it reaches 25% for those born between 1943 and 1954. The reduction further increases by approximately 0.8% for each year of birth between 1955 and 1959 until it plateaus at 30% for those born in 1960 and later.

One other noteworthy item in the fraying of Social Security benefits is the affect of increasing Medicare Part B premiums on one’s Social Security check. While Social Security checks cannot decrease from one year to the next as a result of an increase in the Part B premium for “lower-income” individuals, this isn’t the case for “higher-income” recipients, i.e., those with modified adjusted gross income (“MAGI”) of $85,000 or more.

Beginning in 2007, “higher-income” individuals have been subject to higher Medicare Part B premiums that increase as MAGI exceeds specified thresholds (see the July 5, 2010 post, Will Your Medicare Premium Increase If You Do a Roth IRA Conversion – Part 1 for the 2010 Medicare Part B “higher-income” monthly premium table). As a result of a 14.7% decrease in Medicare Part B premiums and no cost of living adjustment (COLA) from 2009 to 2010, individuals with MAGI of $85,000 or more experienced a corresponding decrease in the amount of their monthly Social Security checks.

As is evident from the legislative history, the Social Security retirement income security blanket, while still intact, is inarguably frayed. With fewer employees paying into the system, increasing numbers of eligible recipients, and record budget deficits, a perfect storm is in place for further benefit reductions and a potential Social Security tax rate increase. Planning for alternative sources of retirement income has never been more important than it is today.

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Medicare Roth IRA

Will Your Medicare Premium Increase If You Do a Roth IRA Conversion? – Part 3

Retirement Income Center

We learned three important things in Parts 1 and 2 of this blog post regarding the potential impact of a Roth IRA conversion on one’s Medicare Part B premium:

  1. 1. The amount of income from the conversion can increase one’s Medicare Part B annual premium by more than $3,000 if single or more than $6,000 if married and both individuals are eligible for Medicare.
  2. The premium increase, if there is one, will occur two years after the year in which the income from the conversion is included on one’s income tax return.
  3. Assuming a 2010 conversion, the premium increase, if there is one, will occur in 2013 and 2014 if the “Default” method is used to report the conversion or in 2012 if the “Election” method is used.

To illustrate, let’s assume that you’re married and you’re both eligible for Medicare, your 2008 Social Security Administration modified adjusted gross income (“SSA MAGI”) was $165,000, and your Medicare Part B premiums are being withheld from your Social Security checks. Per last week’s post, each of your 2010 monthly Medicare Part B premiums would be $96.40. For both of you, this would be $192.80 per month, or $2,313.60 per year. Let’s further assume that your total 2010 Roth IRA conversion income was $540,000 and there have been no other changes to your income since 2008.

Assuming that you went with the default of reporting 50% of your Roth IRA conversion income in 2011 and 50% in 2012, your 2013 and 2014 MAGI would be $435,000 ($165,000 + 50% of $540,000), placing you in the top Medicare Part B premium level per the table in Part 1 of this post (joint return with income above $428,000). Let’s assume that you instead elected to report 100% of your Roth IRA conversion income on your 2010 income tax return. In this case, your 2012 MAGI would be $705,000 ($165,000 + $540,000) and your 2013 and 2014 MAGI would revert to $165,000.

How much would your Medicare Part B premium be over the next several years? As stated above, it depends upon the year(s) in which the income from your 2010 Roth IRA conversion is reported on your income tax returns. The following table shows the amount of a married couple’s Medicare Part B 2010 – 2015 annual premiums unadjusted for future premium increases, assuming base MAGI of $165,000 and 2010 Roth IRA conversion income of $540,000:

Year

Roth Conversion Income Reported 2011 and 2012

Roth Conversion Income Reported 2010

2010

$2,313.60

$2,313.60

2011

$2,313.60

$2,313.60

2012

$2,313.60

$8,486.40

2013

$8,486.40

$2,313.60

2014

$8,486.40

$2,313.60

2015

$2,313.60

$2,313.60

While the amount of the 2010 Roth IRA conversion of $540,000 used in the above example is on the high side, it drives home the point that potential increases in Medicare Part B premiums need to be considered in a Roth IRA conversion analysis for Medicare-eligible individuals. Furthermore, if you do a Roth IRA conversion in 2010, it could increase your Medicare Part B premium amount for two years by more than $3,000 if single and by more than $6,000 if married and both individuals are eligible for Medicare.

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Medicare Roth IRA

Will Your Medicare Premium Increase If You Do a Roth IRA Conversion? – Part 2

Retirement Income Center

Last week’s blog post, Will Your Medicare Premium Increase If You Do a Roth IRA Conversion? began a discussion of how Medicare Part B (medical insurance) premiums are calculated. As discussed last week, of importance is that Social Security Administration (“SSA”) will use the income reported on your federal income tax return from two years prior to the current year to determine the amount of your Part B Medicare premium. Also of importance is the distinction between IRS’ and Social Security Administration’s definition of “modified adjusted gross income,” or “MAGI.”

IRS uses MAGI for various purposes, including calculation of allowable real estate rental losses, deductibility of IRA contributions, and qualification for certain tax credits, to name a few. Prior to 2010, it was also used to determine eligibility for Roth IRA conversions. From 1998 through 2009, only taxpayers with MAGI of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA. For purposes of Roth IRA conversion eligibility determination, income attributable to the conversion was excluded from the calculation of MAGI. There are several adjustments, both negative and positive, made to “adjusted gross income,” or “AGI” to arrive at IRS’ definition of MAGI.

When SSA determines MAGI, the calculation is much simpler than the one used by IRS. SSA’s MAGI calculation increases AGI by tax-exempt interest income and that’s it. Since AGI includes income from Roth IRA conversions, unlike IRS’ pre-2010 Roth IRA conversion eligibility MAGI calculation which excluded income from the conversion, SSA includes Roth IRA conversion income in its MAGI calculation.

What does this mean if you’re a Medicare-eligible individual contemplating a Roth IRA conversion in 2010? Any income resulting from a Roth IRA conversion will be added to your other income to determine the amount of Medicare Part B monthly premium that you will pay two years after the year the Roth IRA conversion is included in your income. Your Medicare Part B premium amount could be greater for either one or two years depending upon whether you use the “default” or “election” method for reporting your 2010 Roth IRA conversion income.

Since Medicare premiums are based on SSA’s calculation of MAGI from your tax return two years prior to the current year and since the default for the reporting of 2010 Roth IRA conversion income is the deferral of 50% of the income to 2011 and 50% to 2012 (See In Which Tax Year(s) Should You Include Your 2010 Roth IRA Conversion Income? – Part 1), depending upon the amount of conversion income, your Medicare Part B annual premium assuming that you are married and both eligible for Medicare could increase by more than $6,000 in both 2013 and 2014 for a 2010 conversion. Alternatively, if you elect to report 100% of the income from your conversion in 2010, your Medicare Part B annual premium could increase by more than $6,000 in 2012.

Next week we will look at an example of how a 2010 Roth IRA conversion can directly impact the amount of your Part B monthly premium.

Categories
Medicare Roth IRA

Will Your Medicare Premium Increase If You Do a Roth IRA Conversion? – Part 1

Retirement Income Center

It’s always amazing to me how one thing in life leads to another. This phenomenon is so true when it comes to the Roth IRA conversion series of blog posts that I’ve been writing and publishing since the beginning of the year, with the first post, Year of the Conversion, published six months ago on January 11th. As an example of the “one thing leads to another” phenomenon, the idea for last week’s post, Got Dormant 401(k)? Consider Converting to a Roth IRA came about as a result of writing the previous week’s post, Don’t Forget About Your SEP-IRA for Roth IRA Conversions.

This week’s post is yet another example of the “one thing leads to another” phenomenon. The second to last paragraph of Got Dormant 401(k)? Consider Converting to a Roth IRA discussed various factors to consider when contemplating the Roth IRA conversion decision. Included in the list of factors was the affect of the conversion on Medicare premiums. Since this is an important consideration for anyone 65 years of age or older who is evaluating a Roth IRA conversion, I am devoting this week and the next two week’s posts to this topic.

For those of you unfamiliar with Medicare insurance premiums and how they’re calculated by Social Security Administration (“SSA”), first some background regarding Medicare insurance premium amounts. There are two types of Medicare premiums: Part A and Part B. Both premium amounts are subject to change each year.

Part A is for hospital insurance. Most people don’t pay a monthly Part A premium because they or a spouse has 40 or more quarters of Medicare-covered employment. The amount of Part A premium is currently $254.00 per month for people having 30 – 39 quarters of Medicare-covered employment and is $461.00 per month for people who are not otherwise eligible for premium-free hospital insurance and have less than 30 quarters of Medicare-covered employment.

Part B is for medical insurance with a basic monthly premium that is currently either $96.40 or $110.50 per month for individuals who file an individual return with modified adjusted gross income (“MAGI”) of $85,000 or less or individuals who file a joint return with MAGI of $170,000 or less. The monthly premium is $96.40 for individuals who have their Part B premium withheld from their Social Security benefits and is $110.50 for all others. The 2010 Part B monthly premium for higher levels of income is as follows:

2010 Part B Monthly Premium

Individual Return With Income

Joint Return With Income

$154.70

$85,001 – $107,000

$170,001 – $214,000

$221.00

$107,001 – $160,000

$214,001 – $320,000

$287.30

$160,001 – $214,000

$320,001 – $428,000

$353.60

Above $214,000

Above $428,000

What’s important to keep in mind is that SSA will use the income reported on your federal income tax return from two years prior to the current year to determine the amount of your Part B Medicare premium. As an example, the income reported on your 2008 federal income tax return will be used to determine your monthly Part B premium in 2010. If your income has decreased since 2008, subject to meeting certain criteria, you may request that the income from a more recent tax year be used to determine your premium.

Part 2 will discuss the distinction between IRS’ and SSA’s definition of “modified adjusted gross income” and how this affects the Medicare Part B monthly premium amount. Part 3 will provide an example of how a 2010 Roth IRA conversion can directly impact the amount of your Part B monthly premium.